8.7 NAV, Total Expense Ratio and Pricing of Units for the Segregated Portfolio

The Problem Segregation Solves

A debt scheme holds a bond that defaults. Its recoverable value is unknown and may take years to establish. Two harms follow immediately if nothing is done:

1. Investors who redeem now take out cash at an NAV that still carries a guess at the defaulted bond's value. If the guess is too high, they leave with more than their share.
2. Investors who stay are left holding a larger proportional share of the distressed asset, and a scheme whose NAV cannot be relied upon.

Worse, redemption pressure forces the manager to sell good assets to meet exits, concentrating the bad asset among those who remain — the classic run dynamic.

Segregation of portfolio, commonly called side-pocketing, addresses this by separating the distressed holding into its own portfolio.

What Triggers Segregation

A segregated portfolio may be created only on a defined credit event at the issuer level:

• A downgrade below investment grade
• Subsequent downgrades of an already sub-investment-grade instrument
• Reverse downgrades following such an event
• An actual default in payment of interest or principal

The scheme must have enabled the facility in its Scheme Information Document. Segregation is not available for a mere fall in market price, an issuer's poor results, or a sector becoming unpopular. The trigger is a credit event, not a value judgement.

The Mechanics

1. The AMC decides on creation of a segregated portfolio on the day of the credit event.
2. Trustee approval is sought; if approved, segregation is effective from the day of the credit event.
3. Every investor holding units on the day of the credit event receives units in the segregated portfolio equal in number to their units in the main portfolio.
4. The main portfolio continues to operate normally, with an NAV reflecting only its remaining, valuable assets.
5. Units of the segregated portfolio must be listed on a recognised stock exchange within ten working days of creation.

Step 3 is the equitable core. The distressed asset stays with exactly the investors who owned it when it went bad. An investor who subscribes the next day gets a clean main portfolio and no claim on the defaulted bond, which is correct — they took none of that risk.

Pricing and Redemption

Because no redemption is possible from the segregated portfolio, the listing requirement is the investor's only liquidity. Units may trade at a steep discount, reflecting genuine uncertainty about recovery. An investor who wants out immediately takes that discount; one who waits receives whatever is actually recovered, when it is recovered.

As amounts are recovered from the defaulted issuer, they are distributed to the segregated portfolio's unitholders in proportion to their holding.

Expenses on a Segregated Portfolio

The rules are deliberately restrictive, because charging fees for managing an asset that is largely a recovery exercise would compound the investor's loss.

• No investment and advisory fees may be charged on the segregated portfolio.
• Other Total Expense Ratio components may be charged on a pro-rata basis only upon recovery of the investments in the segregated portfolio.
• Legal charges related to recovery may be charged to the segregated portfolio in proportion to the amount recovered, subject to a cap of 20 basis points per annum of the daily net assets of the segregated portfolio.
• Costs above that cap are borne by the AMC, not by investors.

Governance Safeguards

Because segregation could otherwise be used to hide poor credit selection, the framework requires:

• Trustee approval for creation
• Immediate disclosure to SEBI and to unitholders, including the credit event, the security segregated, and its value
• Ongoing disclosure of the segregated portfolio's NAV and recovery progress
• Enabling provisions in the Scheme Information Document in advance

What a Distributor Should Say

Investors typically hear about segregation on the day it happens and assume money has been lost. The accurate framing:

"The scheme has moved one defaulted bond into a separate portfolio. Your holding in the main portfolio is unaffected and continues normally. You also hold units in the segregated portfolio representing your share of that bond. Those cannot be redeemed from the fund but will be listed, and you will receive your share of whatever is recovered. Nothing has been written off permanently — the value is uncertain, and segregation prevents that uncertainty from affecting the rest of your investment."